Real Estate Investments and Taxation
Real estate investing can serve to diversify your portfolio. With the housing market stabilized and even trending upward, now might be a reasonable time to jump in. However, just because there are plenty of shows on the HGTV and DIY networks about flipping houses, there’s a lot more to making real estate investments pay off than any of those shows may lead you to believe.
First, what is an “investment property”? It is any real estate that you purchase with the intent of generating income or gain that will not be used as a personal residence. That income can be in the form of monthly rent or appreciation upon selling the property.
In addition to generating income, you can also take advantage of certain tax benefits with investment property.
Investment Property Deductions
In the case of real estate investing, you can deduct expenses that are otherwise non-deductible on your primary residence. For a property that will be held less than a year (in the case of flipping a property), all renovation costs, monthly mortgage interest payments, and staff overhead (e.g. property manager or staff contractor) is deductible. Normally, the goal with a property flip is to gain income through forced appreciation as quickly as possible. Any short-term capital gain (property sold in less than one year) will be taxed at your ordinary income tax rate.
Property held longer than one year is generally held for rental income. Here is a list of items that you can deduct on a rental investment property:
- Auto and Travel Expenses
- Cleaning and Maintenance
- Mortgage Interest
- Legal and Professional Fees
- Management Fees
- Property Taxes
- License Fees
In real estate investing, nearly every invested dollar is tax deductible, including purchase price, property taxes, loan interest, and depreciation. Depreciation can be a big tax advantage for property held longer than one year. By simple definition, depreciation is the reduction in value of a property due to wear and tear over time.
Depreciation of Investment Property
In understanding depreciation on investment property, keep in mind that land does not depreciate, only the structure upon it, so you need to determine the value of the improvement (i.e. the structure) separate from the value of the land. According to the IRS, “Three factors determine how much depreciation you can deduct each year: (1) your basis in the property, (2) the recovery period for the property, and (3) the depreciation method used. You cannot simply deduct your mortgage or principal payments, or the cost of furniture, fixtures, and equipment, as an expense.” Additionally, you can only deduct depreciation on investment property, so if you have a rental unit at your main residence, only the value of the rental property is subject to a depreciation deduction.
In order to depreciate a property, each of the following criteria must be met, according to the IRS:
- You own the property
- You use the property in your business or income-producing activity
- The property has a determinable useful life
- The property is expected to last more than one year
As a very simple example, let’s say the value of a house used as an investment property (excluding the value of the land it sits on) is $200,000. The calculation for depreciation, according to the IRS, is 27.5 years of useful life for a residential structure (39 years for non-residential property). Divide the value ($200,000) by that amount, and the yearly depreciation expense is $7,272.
That would be the amount you would take as a deduction against your annual income. That depreciable deduction also reduces the cost basis of the property which is a determining factor in the gain or loss when it’s time to sell.
Depreciation Recapture Tax
So far, so good. But… Uncle Sam will ultimately want his share, and that occurs in the form of depreciation recapture. You’ve enjoyed a benefit of reducing your income via depreciation, so you paid less overall tax during the time you owned the investment property. When you sell the property, it will be time to pony up. The monies you took as depreciation will be added back to your capital gain, and that recapture tax can be as high as 25 percent.
Let’s look at our example above again, presuming you held the property for five years. In that time, you enjoyed $36,360 ($7,272 x 5) in depreciation and deduction from your taxable income. You sell the property for $250,000, and to keep it as simple as possible, we’ll assume no other deductible expenses at the time of sale. Your capital gain is $86,360. How can that be possible if I only paid $200,000? Well, when you depreciate your property, that reduces your cost basis, so in the eyes of the IRS you actually paid $163,640 ($200,000 – $36,360). Of that $86,360 gain, $36,360 is subject to a maximum 25 percent tax. The remainder will be taxed at your normal capital gain rates (0 to 20 percent).
Depreciation recapture is limited to the lesser of the overall gain or the depreciation you took. If, in our example, you sold the property for $200,000, the entire gain of $36,360 would be taxed at the maximum 25 percent rate.
Joint Property Ownership
There are two ways in which a property can have multiple owners: joint tenancy or tenancy in common (TIC). In joint tenancy, each owner has equal interest. For example, two owners of a rental property each hold 50 percent interest, so expenses and income are shared evenly. However, in TIC, the amounts can be different. For example, in TIC, one owner could hold 60 percent interest with another holding 40 percent interest.
Problems can easily arise at tax time because the IRS isn’t concerned with who owns how much. The IRS sees the property as a single entity. The tax breaks (e.g. depreciation) and other deductions must be determined by the owners, and the IRS will defer to state and local laws regarding legally defined ownership. The situation regarding either joint ownership or TIC can quickly become very complicated. You’d be wise to consult with your attorney and accountant before entering either arrangement. This is especially true regarding investment property!